October 2008

The day I read “Innumeracy“, I began appreciating numbers. Even though I was dealing with numbers prior to that day, that book clearly showed me that I was innumerate .That coupled with my love of life( the book which I have fallen in love and my romance continues till this day) , “The Art of Profitability ” , made me realize that I was total crap in numeracy skills. From that day, I have constantly strived to improved my numeracy skills.

It also meant that I picked up and read almost any book that I came across, which was relevant to numeracy. Last week I chanced upon a wonderful book which belongs to that category. It is titled “Guesstimation”

What’s new in this book ?

It is the first book that I have come across where all the discussion is based on SI system. All my education happened in SI units and in that aspect, this book is a welcome relief where I need to concentrate on only one step , which is guesstimate. I don’t have to keep track of metric system conversions which is a big relief. This book is not a one sitting read book. It has about 50 odd examples and One example a day would do. Like everything else in life ,that you want to master, numeracy skills need to be worked on each day. I haven’t reached the state where I spend atleast a few minutes daily. But I working towards it though. i compare such activities to working out in the gym. The more regular one is, the better one feels about it.

Any ways, happy to have stumbled on to this book, mainly because it deals in SI units!

This is a book which is guaranteed to make you laugh!!! Yes , it is a book on derivatives but it is written in a great humorous style that it WILL MAKE YOU LAUGH. I bet!

I picked up this book almost 10 months back. Speed read it . Had lent it to one of my friends and hence could not write a summary in time. Now that this book is back with me, Let me try to summarize a couple of interesting things from the book.

This book is mainly about the author’s personal experiences as a derivatives trader. The tone of the book is witty and sarcastic from the word go. It gives a sneak peek in to the so called derivative trading world.

Financial WMD’s

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The very first chapter is about the author’s experience with structured products world. Satyajit Das started his banking career in 1977 and those were times the times when emails to put across deals , be it currency swaps or interest rate swaps. The volume and demand for these swap markets lead to the creation of warehouses where firms started taking principal repayment risk too. From the days of 1970s where everyone was taking Chicago Univs word as THE word on finance, author gives a quick summary of events . CBOT , CME exchange formation , evolution of IR Swaps, Currency Swaps, derivative warehouses , 1987 crisis, 1998 LTCM crisis, Inverse floater which screwed Orange County, etc. The first chapter is a whirlwind tour of crisis, structured product market evolution .

Beautiful Lies – Sell Side

Sell side, bankers and dealers comprise this side. The constant turf battles between sales and trading personnel, support and front end teams is brought out in this chapter , again with a sarcastic tone :). It also mentions the ethnic cleansing that has happened over the sell side, with various ethnic groups carving a role for themselves in the entire structure. There are a lot of funny acronyms which are introduced to the reader. One set relates to Management Directors. Considering the innumerable MDs at firms, author comes up with acronyms to categorize them. MD/NR ( Managing Director / Not really ). MD/NVI(Managing Director Not Very Important) MD/PLN(Managing Director / Please leave now). FILTH(Failed in London Try Honkers), LBFM( pls read the book to find out what this acronym stands for 🙂 ..or just take a guess as to what a trader posted in Asia would expect as a perk 🙂

I had a wonderful laugh when author ponders over his perspective on equity analysts and the excruciating detail to which they analyse. He wonders whether the equity analyst is analyzing companies or RUNNING companies 🙂 I get the same feeling too sometimes when I see equity analysts who would have picked up some degree in chemistry or some discipline and they give out buy/sell/hold recommendations using extensive mind blowing analysis . God knows from where they motivate themselves to study a company dealing with live cattle/ pork bellies.. I have always always never ever understood the contribution of equity analysts!!! As the author rightly points out, which I agree fully , equity research is just mean to shove reams of pdfs on to clients side so that they just buy in to the document. After all if somebody does a worthwhile research, the firm will instead use it to trade for itself….so, all the beautiful documents you see out there are just good advertising material !! nothing more than that!!

ok, here are some more funny interpretation of org structures from the author

Diversification : Let’s do several things that we dont know anything about badly
Focus : Lets get back to doing what we once did if anybody can remember what is is and how to do it
Decentralization : Massive duplication, confusion and creation of thousands of petty empires
Matrix Structures: Everybody reports to everybody, no one knows who they work for and there is no accountability
Flat organizations: Managers who can’t manage now manage tens of direct reports
Business Process Reorganization: A process by which you cut everything that is essential, leaving only everything that you don’t need.

:):)

True Lies – Buy Side

Who are the artists on this side 🙂 ? Pension fund managers , Investors, Insurance agencies, banks etc are all the people on this side. This chapter was very very funny. Even though it narrates a couple of crisis that were the result of using derivatives like Proctor & Gamble using IR Swap which blew up, Ashanti gold mines using futures to lock in profits, Walt Disney’s screwed up hedging experience, MG’s fucked up stack trade etc. Overall , if you understand the products or have taken Derivatives 101 course somewhere, you will shudder at the dangerous world of derivatives!!

The best part of the chapter is the author’s take on various investment philosophies and vision statements. Here is a good list that author provides

Index Funds :The fund manager has given up trying to beat the market

Active Management :Triumph of hope over experience

Momentum investing: Shit must be good. Millions of flies cant be wrong 🙂

Value Investing: Pure Luck

Yield enhancement: You are taking on a whole lot of risk. You will be lucky to get your money back

Portfolio Insurance: Hang on, wasnt a return of principal the least that you are entitled to?

This book traces the key events in the US political and economy history that have supposedly led to the current crisis. Books such as these attempt to try to make a good narrative of the events around us. As they say , connecting dots backwards is easy ..and so this book in that sense does a better job.

Usually crisis is associated with a specific asset class. Junk bonds, CMO’s, Real estate, etc. However the current financial crisis is a different one . It is a credit crisis which permeates across all asset classes. It is like poisoning air and there is no respite for any living being in the environment. Credit crisis permeates across all assets as it is the lifeblood of finance and that makes this crisis VERY dangerous. The asset classes which are going to get impacted are not just the dodgy mortgages but Commercial Mortgages, Credit Card debts, High yield bonds, Leverage Loans, Complex bond structures, all in total, according to the author’s estimate is ONE TRILLION DOLLARS!!! That’s equivalent to the GDP of India!! scary to think of it.
LTCM was just 100 billion in positions and 10 million assets at risk. This time , the numbers are scary and bailout means unbelievable sum of money.

Liberalism to Monetarism

The author starts off discussing the era of 1970s , an era characterized by a change of philosophy at the center. Nixon was a liberal who believed in the top down approach. 1970s were bad times for US economy and Nixon tried using the top down approach of price controls, import tax, etc. But by 1980s US was struggling to compete. It has huge inflation , high unemployment .Enter the Keynesian Monetarism. Ronald Reagon was an out and out Monetarist who believed that inflation is always a monetary phenomenon. If the money supply is controlled with respect to economic growth, inflation is always in reins. With this philosophy in mind, US started seeing a new regime , the regime of Monetarism.

Paul Volcker and Inflation

Nixon appointed Paul Volcker as a fed chairman in 1979 and he was a thorough monetarist. With the help of money supply instruments, he successfully brought down the inflation levels . Even though the growth rate became negative, slowly over a period , growth was established and wall street was sold the idea that monetarism is an effective instrument to control the economy. However there were 2 crisis that were a part of 1980s. First being the LBO boom and bust, second being Savings and Loans bubble. Both these incidents illustrate the fragility of free markets.

1990’s is called the Goldilocks economy , a new term which I learned today. An economy which is neither hot, i.e not plagued by inflation nor cold, i.e not plagued by unemployment is called Goldilocks economy. So 90s as such was a happy happy 🙂 period for everyone. With monetarists in control , credit was pushed in to economy and US economy was on a roll.

Not all hunky-dory

It was not that there were no crisis in the markets. There were three significant ones . First was CMO bubble which is a bubble created by tranching a pool of loans and then selling off different pieces to different investors. It was a genuine instrument, until the time when greed took over . 125 tranches became a common place and that was the end of it. CMO market collapsed . Big firms like Kidder Peabody shut their operations. The next crisis worth mentioning are Portfolio insurance crash in 1987 and LTCM debacle in 1998. In all the three stories, there was a common thread. Financial markets were becoming more unregulated, agency problem was becoming more dangerous and the concept of everything can be mathematicized was taking prominence.

Think about it : CMO crisis should have taught us something and subprime crisis could have been averted. Well, there were other forces that were shaping US financial industry. HEDGE Funds and INVESTMENT Banks were transforming the financial markets.

Instruments Galore

From 2000 to mid 2005, US witnessed the biggest housing boom in its history. An increasing housing activity led banks to start issuing instruments to hedge default risk. What started as a hedging exercise resulted in something completely new. Commercial Mortgage securitization was a bit difficult. Hence banks started involving rating agencies. Once rating agencies gave some rating, investors were sold on it. With the rise of hedge funds, credit derivative swaps, the credit market saw a huge increase in notional as well as the type of instruments being traded. 125 tranches for the securitized assets was being done, synthetic CDOs, CDO squares, etc..you name it…all that was needed was a computational power, a few math geeks , greedy investors and the game was set..A bubble was on and it was only a matter of time that party would come to a stop and it did…Housing market slow down blew away a couple of hedge funds AND it was a sign of things to come.

Unwinding Effect

With the easy credit available, the CDO’s made a comeback. Why ? Well there was always a problem to sell the bottom tranche of the structured security. However with hedge funds in play more SIVs were being formed as there were good enough hedge funds to buy the crap. Hedge funds , as of 2007 deployed 2T of capital , and economic capital 5 times the size in to US economy. Usually a credit hedge fund investor is leveraged 100:1 . How is that ? Well 5:1 is the leverage provided by prime broker, and the investment like a CDO typically provides another 20:1 leverage . Thus credit hedge funds are highly leverage plays which provide liquidity to the market. The other players are Ibanks. Thus with I banks and hedge funds providing 50% of credit to the market, there was a huge built of portfolio with dicey assets.

The highlight of this book is a table which the author provides. This table gives author’s estimate of the total unwinding that is due in the US markets. Table is really scary as it says that the mess has just started. Whole lot of asset classes are going to take a hit like credit card industry , high yield corporate bonds, monoline insurers etc. Here is the table. It would be worthwhile to keep a watch on this table and see whether this this is a 1 Trillion mess. The numbers before the brackets denote the outstanding and numbers in brackets denote the estimated loss. There are some asset classes where these numbers are not provided. May be the crap is too exotic to put a number on
All numbers in $Billion

Residential Mortgages

Subprime – 1500 (150)

CDO Bonds – 1200 (300)

Corporate Debt

High Yield bond defaults – 1000(50)

High Yield bond writedowns – 900(180)

CLO Defaults – 500(25)

CLO writedowns – 450(90)

CMBS Defaults – 800(40)

CMBS writedowns – 720 (108)

Credit Cards – 900(67)

Monoline — ??

Credit Default Swap defaults — ??

CDS Writedowns – ??

Leverage Loans – ??

The total mess is about 1Trillion, a conservative estimate.

WOW!! Is this the place to stay and make a career ? Well, looking at the leverage that has been built up, it would take atleast 2-3 years before things return to normalcy…what would quants do till then ? What will other players in the fin industry do ? The other day , one of my friend’s friend, a trader from morgan stanley was asked not to trade for few hours as the situation was hopeless and nobody knew where the market is going. No one knew where is bottom ? US has become , as you would have seen a highly leveraged nation. Consumer spending will remain flat and go down atleast in the coming years. So, where are the opportunities ? Emerging countries are also going to take a hit. This is the best time to start a firm and put some time and effort in building a valuable asset. Any ways, there will not be any earth shattering work in the economy. Hence this is the time to start and work on building an asset. Recession / Depression always gives rise to some spectacular companies. We will see some of them in the years to come.Who are building them ? Well , atleast a few of the brilliant folks from wallstreet who have been hit by the crisis will take the brave step of getting out of the usual rut and work towards building a great asset / value in the coming years.

What’s the prescription ?

The prescription offered by the author should not come as a surprise. Financial regulation and more direct control of the government rather than believing completely in the markets. 1970s and 80s flourished because of free markets . The current crisis is the demonish side of free markets and may be there is a case for going back to liberalism , more govt controlled measures etc. May be. The next president will have a tough job to do . Will the markets which have been given free rein be controlled. it is easy to give away control but very difficult to put controls.

This book certainly makes a very crucial point. US is leverage to hilt and this meltdown will hit all the asset classes and it will take atleast 2-3 years before things return to normal!!